The transition to a low-carbon economy and the role of financing

Climate change is one of the greatest challenges in the 21st century. Limiting global warming to well below 2°C, as agreed under the Paris Agreement, will require substantial low-carbon investments. However, market frictions, such as emission externalities and spillovers from low-carbon innovation, deter private sector investments in low-carbon technologies. Rather recently, scholars increasingly stress the role of functional financial markets for enabling low-carbon investments. In a new paper, my co-author Christian Haas and I introduce the role of financial markets in a theoretical analysis of low-carbon investments. Our paper (i) offers a first theoretical mechanism explaining how information asymmetries between lenders and borrowers might induce credit rationing and thus a socially undesirably low level of low-carbon investment and (ii) analyses how different policy interventions might resolve this issue.

Analysing firm investment and bank lending

In our model, we analyse the decisions of three types of actors: firms (borrowers), banks (lenders), and the government. Firms can choose between continuing to use a dirty technology and a clean/low-carbon technology requiring a risky initial investment, e.g. R&D expenditures. Furthermore, firms are heterogeneous with respect to (i) their dirty technology, i.e. there are high- and low-emission firms, and (ii) their likelihood to successfully invest in a new low-carbon technology. This investment requires external funding, i.e. a bank loan. Due to asymmetric information, the bank cannot distinguish between different firm types.

Main findings of the paper

Without any policy intervention investments in low-carbon technologies are substantially too low from the societal perspective. The government can improve the situation by introducing an appropriate emissions tax. Such a tax provides incentives, in particular for high-emission firms, to switch to low-carbon technologies. However, due to asymmetric information; the bank cannot distinguish between firms and their success probabilities. Banks offer loan conditions that only firms with low risks can accept. Firms with higher risks do not receive financing for their low-carbon investments, although these would be socially desirable. This issue of credit rationing can be resolved by an additional government intervention. A public interest rate subsidy or a loan guarantee can successfully eliminate credit rationing and lead to the first-best outcome.

In addition, we analyse the dynamics of these policy interventions. In the presence of learning effects, credit rationing vanishes due to decreasing risk of low-carbon investments, even without policy intervention on the credit market. Hence, any policy intervention on the credit market is finite. There are, however, costs of delay if the government does not deal with credit rationing.

When is credit rationing likely to occur and what should policy do?

Our analysis shows that credit rationing is more likely if low-carbon technologies are immature and risky. The likelihood increases if financial institutions are unable to screen and asses these risks. Hence, credit rationing is a potential issue in economies with less developed financial sector. Policy makers can use finance instruments to address the credit market friction. Loan guarantees and interest rate subsidies can resolve the issue of credit rationing. It is rather unlikely that credit rationing is a major problem for firms investing in established clean technologies in developed economies, as the US or the EU.

A carbon price is of key importance

Irrespective of the potential issue of credit rationing, a carbon price is the best option to incentivise firms to switch to low-carbon technologies. As firms internalise the social costs of emissions and high-emission firms choose to substitute their dirty production technology by a clean alternative. In an additional analysis, we consider the situation where an emission tax is (politically) not feasible. We show that subsidising low-carbon investment with an interest rate subsidy can be used as an alternative to promote these investments. This alternative, however, leads to lower welfare and higher public expenditures.

Potentially adverse incentives for policy makers

Our dynamic analysis reveals potentially adverse incentives for policy makers. Overall, the positive welfare effect of government intervention preventing credit rationing increases with clean technology risk: the more immature and riskier a low-carbon technology, the more beneficial is policy intervention. The benefits, however, do not occur immediately but rather over a longer period of time depending on the size of learning effects. For rather mature and less risky clean technologies, the social benefit of government support is overall smaller, but materialise relatively quickly. Hence, the more short-sighted the policy makers, the more likely are policies supporting these more mature clean technologies. Government support for riskier low-carbon technologies in less developed economies, however, is more socially beneficial.

Policy implications

In conclusion, the following key messages can be derived from our analysis:

A (global) carbon price is the key for an effective and cost-efficient transition to a low-carbon economy.

Using public finance instruments to address the emission externality is more costly and most likely less effective and hence should never be the first choice.

The role of public finance should be to address financial market imperfections that deter low-carbon investments.

The social benefits of public finance interventions are particularly high in the case of immature and risky low-carbon technologies and / or less developed financial markets. Myopic policy makers, however, might have incentives to choose the opposite.

The current version of the full working paper can be downloaded here. Other publications of the FS-UNEP Centre research group can be found on our website.